Difference between revisions of "Arbitrage" - New World Encyclopedia

From New World Encyclopedia
(started)
 
(53 intermediate revisions by 7 users not shown)
Line 1: Line 1:
−
{{Claimed}}{{Started}}
+
{{Images OK}}{{Approved}}{{copyedited}}
 
[[Category:Politics and social sciences]]
 
[[Category:Politics and social sciences]]
 
[[Category:Economics]]
 
[[Category:Economics]]
 +
{{Finance sidebar}}
 +
In [[economics]] and [[finance]], '''arbitrage''' refers to the simultaneous sale and purchase of identical [[Security (finance)|securities]] or other financial instruments on different [[market]]s to take advantage of price differentials for [[profit]]. This is also known as a "riskless profit."
  
−
In [[economics]] and [[finance]], '''arbitrage''' is the practice of taking advantage of a price differential between two or more [[market]]s: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the [[market price]]s. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit.  A person who engages in arbitrage is called an '''arbitrageur'''. The term is mainly applied to trading in [[financial instruments]], such as [[Bond (finance)|bond]]s, [[stock]]s, [[derivative (finance)|derivatives]], [[Commodity|commodities]] and [[currency|currencies]].
+
Alternatively, arbitrage is attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. The ideal version is riskless arbitrage. Risk arbitrage, also known as "speculation," while technically not true arbitrage also exists in a variety of forms. Arbitrage is not illegal, although the temptation to make easy profit has led some to use confidential information about forthcoming situations for personal gain, an illegal activity known as [[insider trading]].
 +
{{toc}}
 +
Arbitrage opportunities are not necessarily available to all, and they are generally short-lived as the transactions affect prices so that the arbitrage opportunity is quickly eliminated. Nevertheless, the idea of profit that is essentially risk-free and requires no apparent work appears attractive to many who continue to seek and exploit arbitrage opportunities. Interestingly, it appears that they also contribute to market efficiency, a benefit to society as a whole.
  
−
If the market prices do not allow for profitable arbitrage, the prices are said to constitute an '''arbitrage equilibrium''' or '''arbitrage free''' market. An arbitrage equilibrium is a precondition for a [[general equilibrium|general economic equilibrium]].
+
==Definition==
 +
'''Arbitrage''' is the simultaneous purchase and sale of an asset in order to [[profit]] from a difference in the [[price]]. This usually takes place on different exchanges or marketplaces.  
  
−
[[Statistical arbitrage]] is an imbalance in expected values. A casino has a statistical arbitrage in almost every game of chance that it offers.
+
For example, a domestic stock may also trade on a foreign exchange in another country, where it has not adjusted for the constantly changing [[exchange rate]]. A trader may purchase the stock where it is undervalued and short sell the stock where it is overvalued, thus profiting from the difference.  
  
−
== Conditions for arbitrage ==
+
When the purchase and sale transactions are simultaneous, it may be called '''riskless profit.'''
−
Arbitrage is possible when one of three conditions is met:
 
  
−
#The same asset does not trade at the same price on all markets ("[[law of one price|the law of one price]]").
+
An individual who seeks out and takes advantage of arbitrage opportunities to make profit is known as an '''arbitrageur.'''
−
#Two assets with identical cash flows do not trade at the same price.
 
−
#An asset with a known price in the future does not today trade at its future price [[discount]]ed at the [[risk-free interest rate]] (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for [[security (finance)|securities]]).
 
  
−
Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur ''simultaneously'' to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete. In practical terms, this is generally only possible with securities and financial products which can be traded electronically.
+
Since the actions of arbitrageurs influence the market, particularly in takeover situations there is a temptation for parties involved to communicate information about such activities to arbitrageurs in advance of any public announcement. This is known as [[insider trading]] and is generally illegal.
  
−
In the most simple example, any good sold in one market should sell for the same price in another. [[Trader]]s may, for example, find that the price of wheat is lower in agricultural regions than in cities, purchase the good, and transport it to another region to sell at a higher price. This type of price arbitrage is the most common, but this simple example ignores the cost of transport, storage, risk, and other factors. "True" arbitrage requires that there be no market risk involved. Where securities are traded on more than one exchange, arbitrage occurs by simultaneously buying in one and selling on the other.
+
===Etymology===
 +
''Arbitrage'' is a [[French language|French]] word and denotes a decision by an arbitrator or [[arbitration]] tribunal. (In modern French, ''arbitre'' usually means [[referee]] or [[umpire]]).  
  
−
See [[rational pricing]], particularly [[rational pricing#Arbitrage mechanics|arbitrage mechanics]], for further discussion.
+
In the sense used in [[economics]] it was first defined in 1704 by Mathieu de la Porte in his treatise, ''La science des négocians et teneurs de livres'' as a consideration of different [[exchange rate]]s to recognize the most profitable places of issuance and settlement for a bill of exchange ''([U]ne combinaison que l’on fait de plusieurs Changes, pour connoître quelle Place est plus avantageuse pour tirer et remettre)''.  
  
−
== Examples ==
+
===Conditions of arbitrage===
−
* Suppose that the [[exchange rate]]s (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $12. Converting ¥1000 to $12 in Tokyo and converting that $12 into ¥1200 in London, for a profit of ¥200, would be arbitrage. In reality, this "[[triangle arbitrage]]" is so simple that it almost never occurs.  But more complicated foreign exchange arbitrages, such as the spot-forward arbitrage (see [[interest rate parity]]) are much more common.
+
<blockquote>I don't throw darts at a board. I bet on sure things. Read Sun-tzu, The Art of War. Every battle is won before it is ever fought.</blockquote>
  
−
*One example of arbitrage involves the [[New York Stock Exchange]] and the [[Chicago Mercantile Exchange]]. When the price of a stock on the NYSE and its corresponding [[futures contract]] on the CME are out of sync, one can buy the less expensive one and sell the more expensive.  Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the smartest mathematicians take advantage of series of small differentials that would not be profitable if taken individually.
+
These words come from the 1987 movie ''Wall Street,'' spoken by Gordon Gekko who makes a fortune as a pioneer of arbitrage.  
  
−
*Economists use the term "global labor arbitrage" to refer to the tendency of manufacturing jobs to flow towards whichever country has the lowest wages per unit output at present and has reached the minimum requisite level of political and economic development to support [[industrialization]]. At present, many such jobs appear to be flowing towards [[People's Republic of China|China]], though some which require English are going to [[India]] and the [[Philippines]].
+
Arbitrage opportunities exist when the "[[law of one price]]" is (temporarily) violated. This "law" states that: "In an efficient market all identical goods must have only one price." This is because all sellers flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market the convergence on one price is instant. Under certain conditions, the convergence takes time, during which there exists an arbitrage opportunity.
  
−
*Sports arbitrage - numerous [[internet]] [[bookmakers]] offer odds on the outcome of the same event. Any given bookmaker will weight their odds so that no one [[customer]] can cover all outcomes at a profit against their books.  However, in order to remain competitive their margins are usually quite low. Different bookmakers may offer different odds on the same outcome of a given event; by taking the best odds offered by each bookmaker, a customer can under some circumstances cover all possible outcomes of the event and lock a small risk-free profit, known as a [[Dutch book]]. This profit would typically be between 1% and 5% but can be much higher. One problem with sports arbitrage is that bookmakers sometimes make mistakes and this can lead to an invocation of the 'palpable error' rule, which most bookmakers invoke when they have made a mistake by offering or posting incorrect odds. As bookmakers become more proficient, the odds of making an 'arb' usually last for less than an hour and typically only a few minutes. Furthermore, huge bets on one side of the market also alert the bookies to correct the market.
+
In the [[derivative (finance)|derivatives]] market the law applies to [[financial instrument]]s which appear different, but which resolve to the same set of cash flows. Any particular [[Security (finance)|security]] must have a single price, although it may be created in a number of different ways. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same. When they are not the same, an arbitrage opportunity exists.
  
−
*[[Exchange-traded fund]] arbitrage - Exchange Traded Funds allow authorized participants to exchange back and forth between shares in underlying securities held by the fund and shares in the fund itself, rather than allowing the buying and selling of shares in the ETF directly with the fund sponsor. ETFs trade in the open market, with prices set by market demand. An ETF may trade at a premium or discount to the value of the underlying assets. When a significant enough premium appears, an arbitrageur will buy the underlying securities, convert them to shares in the ETF, and sell them in the open market. When a discount appears, an arbitrageur will do the reverse. In this way, the arbitrageur makes a low-risk profit, while fulfilling a useful function in the ETF marketplace by keeping ETF prices in line with their underlying value.
+
Arbitrage is possible when one of three conditions is met (Kuepper 2008):
 +
#The same asset does not trade at the same price on all markets
 +
#Two assets with identical cash flows do not trade at the same price
 +
#An asset with a known price in the future does not today trade at its future price [[discount]]ed at the [[risk-free interest rate]] (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for [[grain]] but not for securities)
  
−
* Some types of [[hedge fund]]s make use of a modified form of arbitrage to profit. Rather than exploiting price differences between identical assets, they will purchase and sell [[security (finance)|securities]], [[asset]]s and [[Derivative (finance)|derivatives]] with similar characteristics, and [[hedge (finance)|hedge]] any significant differences between the two assets. Any difference between the hedged positions represents any remaining risk (such as basis risk) plus profit; the belief is that there remains some difference which, even after hedging most risk, represents pure profit. For example, a fund may see that there is a substantial difference between U.S. dollar debt and local currency debt of a foreign country, and enter into a series of matching trades (including currency swaps) to arbitrage the difference, while simultaneously entering into [[credit default swap]]s to protect against [[country risk]] and other types of specific risk.
+
Thus, to summarize: Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur ''simultaneously'' to avoid exposure to market [[risk]], or the risk that prices may change on one market before both transactions are complete.  
  
−
==Price convergence==
+
In practical terms, though, this is generally only possible with securities and financial products which can be traded electronically. Such risk-free trading is not available to everyone.
−
Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency [[exchange rate]]s, the price of [[commodities]], and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce [[price discrimination]] by encouraging people to buy an item where the price is low and resell it where the price is high, as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets.
+
 
 +
==Types of arbitrage==
 +
In the world financial community, arbitrage refers to two basic types of activities. One requires little or no risk on the part of the investor, and the other can be highly speculative.
 +
As said above, in its purest form, arbitrage contains no element of risk. True arbitrage is a trading strategy that requires no investment of [[capital (economics)|capital]], cannot lose money, and the odds favor it making money. Any transaction or portfolio that is risk-free and makes a profit is also considered arbitrage.
 +
 
 +
The "market makers" (large firms operating on [[Wall Street]], for example) have several advantages over retail traders (Kuepper 2008), including:
 +
*Great trading capital
 +
*More skill and experience
 +
*Instant news
 +
*More complex [[computer]] software
 +
*Access to the dealing deske
  
−
Arbitrage moves different currencies toward [[purchasing power parity]]. As an example, assume that a car purchased in [[United States|America]] is cheaper than the same car in Canada. Canadians would buy their cars across the border to exploit the arbitrage condition. At the same time, Americans would buy US cars, transport them across the border, and sell them in Canada. Canadians would have to buy American Dollars to buy the cars, and Americans would have to sell the Canadian dollars they received in exchange for the exported cars. Both actions would increase demand for US Dollars, and supply of Canadian Dollars, and as a result, there would be an appreciation of the US Dollar. Eventually, if unchecked, this would make US cars more expensive for all buyers, and Canadian cars cheaper, until there is no longer an incentive to buy cars in the US and sell them in Canada.
+
Market makers use complex software to locate arbitrage opportunities constantly. Once found, the differential is typically negligible, and requires a vast amount of [[capital (economics)|capital]] in order to make a worthwhile profit; retail traders would lose their profit in [[Commission (remuneration)|commission]] costs. Thus, it is almost impossible for retail traders to compete in most types of arbitrage. Nevertheless, there are other arbitrage opportunities available.
−
More generally, international arbitrage opportunities in [[commodity|commodities]], goods, [[security|securities]] and [[currency|currencies]], on a grand scale, tend to change [[exchange rate]]s until the [[purchasing power]] is equal.
 
  
−
In reality, of course, one must consider taxes and the costs of travelling back and forth between the US and Canada. Also, the features built into the cars sold in the US are not exactly the same as the features built into the cars for sale in Canada, due, among other things, to the different emissions and other auto regulations in the two countries. In addition, our example assumes that no duties have to be paid on importing or exporting cars from the USA to Canada.
+
===Riskless or “true” arbitrage===
−
Similarly, most [[asset]]s exhibit (small) differences between countries, and [[transaction cost]]s, taxes, and other costs provide an impediment to this kind of arbitrage.
+
Risk-less arbitrage is arbitrage when attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms:
 +
<blockquote>A combination of transactions designed to profit from an existing discrepancy among prices, exchange rates, and/or interest rates on different markets without risk of these changing. Simplest is simultaneous purchase and sale of the same thing in different markets (Deardoff 2006).</blockquote>
  
−
Similarly, arbitrage affects the difference in interest rates paid on government bonds, issued by the various countries, given the expected depreciations in the currencies, relative to each other (see [[interest rate parity]]).
+
If an item can be bought for $5, and sold immediately for $20 on a different market, that is arbitrage. The $15 difference represents an arbitrage profit.  
  
−
== Risks ==
+
Arbitrage of this "One good, Two markets" variety is quite common in the world of [[sports]] [[gambling]], since different betting agencies often post different odds on the outcome of a game. There are numerous bookmakers especially on the [[internet]], and they offer a variety of odds on the same event. Any given bookmaker weights their odds so that no single customer can cover all outcomes at a profit. However, different bookmakers may offer different odds on the various outcomes. By taking the best odds offered by each bookmaker a customer may be able to cover all possible outcomes of the event and lock in a (small) risk-free profit.
−
Arbitrage transactions in modern securities markets involve fairly low risks. Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. There is also counter-party risk, that the other party to one of the deals fails to deliver as agreed; though unlikely, this hazard is serious because of the large quantities one must trade in order to make a profit on small price differences. These risks become magnified when [[Leverage (finance)|leverage]] or borrowed money is used.  
 
  
−
Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable. In the extreme case this is risk arbitrage, described below. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.
+
Several other types of risk-less arbitrage exist (Reverre, 2001):
 +
;Inward arbitrage
 +
This form of arbitrage involves rearranging a [[bank]]'s cash by borrowing from the inter-bank market, and re-depositing the borrowed money locally at a higher [[interest rate]]. The bank will make money on the spread between the interest rate on the local [[currency]], and the interest rate on the borrowed currency.
  
−
Competition in the marketplace can also create risks during arbitrage transactions. As an example, if one was trying to profit from a price discrepancy between IBM on the NYSE and IBM on the London Stock Exchange, they may purchase a large number of shares on the NYSE and find that they cannot simultaneously sell on the LSE.  This leaves the arbitrageur in an unhedged risk position.
+
Inward arbitrage works because it allows the bank to borrow at a cheaper rate than it could in the local currency market. For example, assume an American bank goes to the Interbank market to borrow at the lower eurodollar rate, and then deposits those eurodollars at a bank within the U.S. The larger the spread, the more money that can be made.
  
−
In the 1980s, [[risk arbitrage]] was common. In this form of [[speculation]], one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price&mdash;if the merger goes through as predicted. Traditionally, arbitrage transactions in the securities markets involve high speed and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act). When the transaction involves a delay of weeks or months, as above, it may entail considerable risk if borrowed money is used to magnify the reward through leverage.  One way of reducing the risk is through the [[Insider trading|illegal use of inside information]], and in fact risk arbitrage with regard to [[leveraged buyout]]s was associated with some of the famous financial scandals of the 1980s such as those involving [[Michael Milken]] and [[Ivan Boesky]].
+
;Outward arbitrage
 +
This form of arbitrage involves the rearrangement of a bank's cash by taking its local currency and depositing it into eurobanks. The interest rate will be higher in the inter-bank market, which will enable the bank to earn more on the interest it receives for the use of its cash.
  
−
==Types of arbitrage==
+
Outward arbitrage works because it allows the bank to lend for more abroad then it could in the local market. For example, assume an American bank goes to the inter-bank market to lend at the higher eurodollar rate. Money will be shifted from an American bank's branch within the U.S. to a branch located outside of the U.S. The bank will earn revenues on the spread between the two interest rates. The larger the spread, the more will be made.
−
=== Merger arbitrage ===
 
−
Also called [[risk arbitrage]], merger arbitrage generally consists of buying the stock of a company that is the target of a [[takeover]] while [[Short (finance)|shorting]] the stock of the acquiring company.
 
  
−
Usually the market price of the target company is less than the price offered by the acquiring company.
+
;Triangular arbitrage
−
The spread between these two prices depends mainly on the probability and the timing of the takeover being completed as well as the prevailing level of interest rates.
+
This is the process of converting one currency to another, converting it again to a third currency, and finally converting it back to the original currency within a short time span. This opportunity for riskless profit arises when the currency's exchange rates do not exactly match up. Triangular arbitrage opportunities do not happen very often and when they do, they only last for a matter of seconds. Traders that take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or programs to automate the process.
  
−
The bet in a merger arbitrage is that such a spread will eventually be zero, if and when the takeover is completed.  The risk is that the deal "breaks" and the spread massively widens.
+
'''EXAMPLE:''' Suppose the following exchange rates exist:
  
−
=== Municipal bond arbitrage ===
+
EUR/USD = 0. 8631, EUR/GBP = 1. 4600 and USD/GBP = 1. 6939.  
−
Also called ''municipal bond relative value arbitrage'', ''municipal arbitrage'', or just ''muni arb'', this hedge fund strategy involves one of two approaches.
 
  
−
Generally, managers seek relative value opportunities by being both long and short municipal bonds with a duration-neutral book. The relative value trades may be between different issuers, different bonds issued by the same entity, or capital structure trades referencing the same asset (in the case of revenue bonds). Managers aim to capture the inefficiencies arising from the heavy participation of non-economic investors (i.e., high income "buy and hold" investors seeking tax-exempt income) as well as the "crossover buying" arising from corporations' or individuals' changing income tax situations (i.e., insurers switching their munis for corporates after a large loss as they can capture a higher after-tax yield by offsetting the taxable corporate income with underwriting losses).  There are additional inefficiencies arising from the highly fragmented nature of the municipal bond market which has two million outstanding issues and 50,000 issuers in contrast to the Treasury market which has 400 issues and a single issuer.
+
With these exchange rates there is an arbitrage opportunity. For example, starting with $1 million, the following transactions can be made:
 +
#Sell dollars for euros: $1 million x 0.8631 = 863,100 euros
 +
#Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds
 +
#Sell pounds for dollars: 591,164.40 x 1.6939 =$1,001,373 dollars
  
−
Second, managers construct leveraged portfolios of AAA- or AA-rated tax-exempt municipal bonds with the duration risk hedged by [[Short selling|shorting]] the appropriate ratio of taxable corporate bonds.  These corporate equivalents are typically [[interest rate swaps]] referencing Libor [http://en.wikipedia.org/wiki/Libor#LIBOR-based_derivatives] or BMA (short for Bond Market Association [http://www.bondmarkets.com/story.asp?id=1157]).  The arbitrage manifests itself in the form of a relatively cheap longer maturity municipal bond, which is a municipal bond that yields significantly more than 65% of a corresponding taxable corporate bond.  The steeper slope of the municipal yield curve allows participants to collect more after-tax income from the municipal bond portfolio than is spent on the interest rate swap; the carry is greater than the hedge expense.  Positive, tax-free carry from muni arb can reach into the double digits.  The bet in this municipal bond arbitrage is that, over a longer period of time, two similar instruments—municipal bonds and interest rate swaps—will correlate with each other; they are both very high quality credits, have the same maturity and are denominated in U.S. dollars.  Credit risk and duration risk are largely eliminated in this strategy.  However, basis risk arises from use of an imperfect hedge, which results in significant, but range-bound principal volatility.  The end goal is to limit this principal volatility, eliminating its relevance over time as the high, consistent, tax-free cash flow accumulates.  Since the inefficiency is related to government tax policy, and hence is structural in nature, it has not been arbitraged away.
+
These transactions yield an arbitrage profit of $1,373 (assuming no transaction costs or taxes) which is the positive difference between the three “almost” simultaneous transactions leading to $1,001,373, from which one subtracts the original outlay of $1,000,000 to yield of net profit of $1,373.
  
−
=== Convertible bond arbitrage ===
+
===Risk arbitrage===  
−
A [[convertible bond]] is a [[bond (finance)|bond]] that an investor can return to the issuing company in exchange for a predetermined number of shares in the company.
+
Risk arbitrage, unlike “true” or risk-less arbitrage, does entail risk. Although considered "speculation," risk arbitrage has become one of the most popular (and retail trader friendly) forms of arbitrage.  
  
−
A convertible bond can be thought of as a [[corporate bond]] with a stock [[call option]] attached to it.
+
'''EXAMPLE:''' Corporation A trades trading at $12 per share. Corporation B determines to acquire Corporation A, placing a takeover bid on Corporation A for $16 per share. This means that all shares in Corporation A increase their value to $16 per share, although they are trading at only $12 per share.  
  
−
The price of a convertible bond is sensitive to three major factors:
+
Early trades bid the price up to $15 per share. A $1 per share difference still exists—an opportunity for risk arbitrage. The risk lies in the probability that the acquisition might fail to take place, in which case the shares would be worth only the original $12 per share.
  
−
*''[[interest rate]]''. When rates move higher, the bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower).
+
Some of the most common forms of risk arbitrage available to retail traders include:
−
*''stock price''. When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.
 
−
*''[[credit spread (bond)|credit spread]]''. If the creditworthiness of the issuer deteriorates (e.g. [[credit rating agency|rating]] downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).
 
  
−
Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value.
+
;Statistical arbitrage
 +
This is an attempt to profit from pricing inefficiencies that are identified through the use of mathematical models. Statistical arbitrage attempts to profit from the likelihood that prices will trend toward a historical norm. It is an equity trading strategy that employs time series methods to identify relative mispricings between stocks (Ross 1976, Burmeister 1986).
 +
;Pairs trading
 +
Pairs trading, also known as relative-value arbitrage, is a far less common form (Reverre 2001). This form of arbitrage relies on a strong correlation between two related or unrelated securities. It is primarily used during sideways markets as a way to profit.  
  
−
Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price.
+
The basis of this arbitrage is finding "pairs." Typically, high-probability pairs are stocks in the same industry with similar long-term trading histories. One example of securities that would be used in a pairs trade is [[General Motors Corporation|GM]] and [[Ford Motor Company|Ford]]. These two companies have a 94 percent [[correlation]] which means that both securities mapped on the time plot move almost exactly in parallel. If a significant divergence occurs, the chances are high that these two prices will eventually return to a higher correlation (the parallel behavior), offering an opportunity in which profit can be attained (Kuepper 2008).
  
−
For instance an arbitrageur would first buy a convertible bond, then sell [[fixed income]] [[securities]] or [[interest rate future]]s (to hedge the interest rate exposure) and buy some [[credit default swap|credit protection]] (to hedge the risk of credit deterioration).
+
;Takeover and merger arbitrage
−
Eventually what he'd be left with is something similar to a call option on the underlying stock, acquired at a very low price.
+
The earlier example of risk arbitrage involving the acquisition of Corporation A by Corporation B demonstrates takeover and merger arbitrage. It is probably the most common type of arbitrage. This typically involves an undervalued business that has been targeted by another corporation for a takeover bid. The takeover bid raises the value because in order to purchase the target corporation they must offer to buy their stock at higher than market price. Once the takeover is announced, the market price price rises to (or at least close to) that offered price. By identifying a company targeted for takeover arbitrageurs can buy stock at the pre-takeover price and sell them after the takeover has been completed at the higher price. If the merger or takeover goes through successfully, all those who took advantage of the opportunity make a significant profit; if it falls through, however, the price usually falls. That is, the element of risk that is always there.  
−
He could then make money either selling some of the more expensive options that are openly traded in the market or [[delta hedging]] his exposure to the underlying shares.
 
  
−
=== Depository receipts ===
+
The key to success in this type of arbitrage is speed; traders who utilize this method usually have access to streaming market news. Within seconds of an announcement they can act, before regular retail traders. However, even though retail traders are not the first to take advantage of a merger arbitrage opportunity, there is still some chance of profit. [[Benjamin Graham]] developed a risk-arbitrage formula to determine optimal risk/reward (Graham and Buffet 1985). The equations state the following:
−
A [[depository receipt]] is a security that is offered as a "tracking stock" on another foreign market. For instance a [[China|Chinese]] company wishing to raise more money may issue a depository receipt on the [[New York Stock Exchange]], as the amount of capital on the local exchanges is limited. These securities, known as ADRs ([[American Depositary Receipt]]) or GDRs ([[Global Depositary Receipt]]) depending on where they are issued, are typically considered "foreign" and therefore trade at a lower value when first released. However, they are exchangeable into the original security (known as [[fungibility]]) and actually have the same value. In this case there is a spread between the perceived value and real value, which can be extracted. Since the ADR is trading at a value lower than what it is worth, one can purchase the ADR and expect to make money as its value converges on the original. However there is a chance that the original stock will fall in value too, so by shorting it you can hedge that risk.
 
  
−
===Regulatory arbitrage===
+
'''Annual Return = [C. (G-L). (100%-C)] /YP,''' where:
−
Regulatory arbitrage is where a regulated institution takes advantage of the difference between its real (or economic) [[risk]] and the regulatory position. For example, if a bank, operating under the [[Basel I]] accord, has to hold 8% capital against [[default risk]], but the real risk of default is lower, it is profitable to [[Securitization|securitise]] the loan, removing the low risk loan from its portfolio. On the other hand, if the real risk is higher than the regulatory risk then it is profitable to make that loan and hold on to it, provided it is priced appropriately.
+
* C is the expected chance of success (percent)
 +
* P is the current price of the security
 +
* L is the expected loss in the event of a failure (usually original price)
 +
* Y is the expected holding time in years (usually the time until the merger takes place)
 +
* G is the expected gain in the event of a success (usually takeover price)
  
−
This process can increase the overall riskiness of institutions under a risk insensitive regulatory regime, as described by [[Alan Greenspan]] in his October 1998 speech on [http://www.ny.frb.org/research/epr/98v04n3/9810gree.pdf The Role of Capital in Optimal Banking Supervision and Regulation].
+
;Liquidation arbitrage
 +
This type of arbitrage involves identifying companies that have a higher [[liquidation]] value than their market price. For example, a business has a book value of $15 per share but is trading at $12 per share. If the business is liquidated its share rise to the higher value. In the ''Wall Street'' movie, Gordon Gekko bought companies, breaking them apart and selling them at higher prices, and was able to realize significant profit through this type of arbitrage.  
  
−
In economics, regulatory arbitrage (sometimes, tax arbitrage) may be used to refer to situations when a company can choose a nominal place of business with a regulatory, legal or tax regime with lower costs. For example, an [[insurance]] company may choose to locate in [[Bermuda]] due to preferential tax rates and policies for insurance companies. This can occur particularly where the business transaction has no obvious physical location: in the case of many financial products, it may be unclear "where" the transaction occurs.
+
;Fixed income trading
 +
Fixed income arbitrageurs try to identify when historical patterns for spreads or term structure relationships have been violated and there is anticipation of the historical relationship being re-established. They also look for situations where credit risk or liquidity risk is being over compensated.  
  
−
===Telecom arbitrage===
+
[[Central bank]] intervention in the markets often creates abnormalities that can be exploited. A typical example is the 2008 crash of the sub-prime [[mortgage]] market in the U. S. Apart from the multi-billion losses, there was an opportunity to make a profit on the expectation that the [[Federal Reserve]] would eventually step in and invigorate the market, albeit for a short-term.  
−
Telecom arbitrage companies like [http://www.actiontelecom.co.uk Action Telecom UK] allow mobile phone users to make international calls for free through certain access numbers. The telecommunication arbitrage companies get paid an interconnect charge by the UK mobile networks and then buy international routes at a lower cost. The calls are seen as free by the UK contract mobile phone customers since they are using up their allocated monthly minutes rather than paying for additional calls. The end effect is telecom arbitrage. This is usually marketed as "free international calls." The profit margins are usually very small. However, with enough volume, enough money is made from the cost difference to turn a profit. This is very similar to [http://www.futurephone.com Future Phone] in the US.
 
  
−
===Online advertising arbitrage===
+
Fixed income arbitrage strategies are generally implemented to be duration neutral, but they are exposed to various other market risks. By their nature, particular strategies may be exposed to tilts in the term structure, spread risk, and foreign exchange risk.  
−
Online ad services like [http://searchmarketing.yahoo.com Yahoo! Search Marketing] and [https://adwords.google.com Google Adwords] allow you to purchase online advertisements which cost you an agreed upon cost per click. These are known as PPC (Pay Per Click) ads. Some ad clicks will cost advertisers $0.01 while some can cost well over $10 depending on the keywords that were associated with the ad. Yahoo and [https://www.google.com/adsense Google] both have programs which allow web publishers (aka owners of websites) to place ads on their own websites to make money. Some webmasters will make a website associated with a high paying keyword(s) and place PPC ads on it. Then, they will purchase low cost ads on Yahoo and Google for their websites. The end effect is traffic arbitrage. Low cost traffic is redirected towards pages which contain high paying links. Enough money is made from clicks to cover the traffic cost and turn a profit.
 
  
−
This is not arbitrage as defined above. The owner of the website is simply betting that the income from the [[affiliate marketing]] organisation is more than the cost of bringing visitors to the site. The website owner must pay the [[search engine]] for each visitor to the website but payment from the affiliate only occurs if the visitor actually clicks onto one of the affiliate advertisements. A classic example might be where each visitor to the site costs the site owner 10 cents but an affiliate marketer will pay the website owner 10 dollars if that visitor clicks through to the target website. In this case if more than 1 in 100 visitors click through then the site makes a profit; and conversely if less than 1 in 100 click through then the site makes a loss. The same theory holds true if the affiliate is the same (or another) search engine.
+
;Convertible-bond arbitrage
 +
A [[convertible bond]] is a [[bond (finance) |bond]] that an investor can return to the issuing company in exchange for a predetermined number of shares in the company. A convertible bond can be thought of as a [[corporate bond]] with a stock [[call option]] attached to it (Chen, 1983). Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value (Ross 1976, Burmeister 1986).  
  
−
==The debacle of Long-Term Capital Management==
+
The price of a convertible bond is sensitive to three major factors:
−
{{main|Long-Term Capital Management}}
+
#[[Interest rate]]: When rates move higher, the [[corporate bond]] part of a convertible bond tends to move lower, but the [[call option]] part of a convertible bond moves higher (and the aggregate tends to move lower).
 +
#Stock price: When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.
 +
#[[credit spread (bond)|Credit spread]]: If the creditworthiness of the issuer deteriorates (for example, [[credit rating agency|rating]] downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).
  
−
[[Long-Term Capital Management]] (LTCM) lost 4.6 billion U.S. dollars in [[fixed income arbitrage]] in September 1998. LTCM had attempted to make money on the price difference between different [[Bond (finance)|bond]]s. For example, it would sell [[Treasury security|U.S. Treasury securities]] and buy Italian bond futures.  The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge.  Because the difference was small, a large amount of money had to be borrowed to make the buying and selling profitable.
+
Convertible arbitrage consists of buying a convertible bond and [[hedge (finance)|hedging]] (making an investment specifically to reduce or cancel out the risk in another investment) two of the three factors in order to gain exposure to the third factor at a very attractive price (Bjork 2004, Chen 1983). For instance an arbitrageur would first buy a convertible bond, then sell [[fixed income]] [[securities]] or [[interest rate future]]s (to hedge the interest rate exposure) and buy some [[credit default swap|credit protection]] (to hedge the risk of credit deterioration).
  
−
The downfall in this system began on August 17, 1998, when [[Russia]] defaulted on its [[Russian ruble|ruble]] debt and domestic dollar debt.  Because the markets were already nervous due to the [[Asian financial crisis]], investors began selling non-U.S. treasury  debt and buying U.S. treasuries, which were considered a safe investment.  As a result the return on U.S. treasuries began decreasing because there were many buyers, and the return on other bonds began to increase because there were many sellers.  This caused the difference between the returns of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting.  Eventually this caused LTCM to fold, and their creditors had to arrange a bail-out. More controversially, officials of the [[Federal Reserve]] assisted in the negotiations that led to this bail-out, on the grounds that so many companies and deals were intertwined with LTCM that if LTCM actually failed, they would as well, causing a collapse in confidence in the economic system.  Thus LTCM failed as a fixed income arbitrage fund, although it is unclear what sort of profit was realized by the banks that bailed LTCM out.
+
Eventually what is left is something similar to a call option on the underlying stock, acquired at a very low price. Profit can then be made either selling some of the more expensive options that are openly traded in the market or [[delta hedging]] his exposure to the underlying shares.
  
−
== Etymology ==
+
==Price convergence==
−
"Arbitrage" is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, "''arbitre''" usually means [[referee]] or [[umpire]]). In the sense used here it is first defined in 1704 by Mathieu de la Porte in his treatise "La science des négocians et teneurs de livres" as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ("[U]ne combinaison que l’on fait de plusieurs Changes, pour connoître quelle Place est plus avantageuse pour tirer et remettre"). See "Arbitrage" in [http://atilf.atilf.fr Trésor de la Langue Française].
+
Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency [[exchange rate]]s, the price of [[commodities]], and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce [[price discrimination]] by encouraging people to buy an item where the price is low and resell it where the price is high, as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets.
  
 +
Arbitrage moves different currencies toward [[purchasing power parity]]. Similarly, arbitrage affects the difference in interest rates paid on government bonds issued by the various countries, given the expected depreciations in the currencies relative to each other.
  
 +
Efficient financial markets should operate without allowing the existence of arbitrage opportunities, since potential borrowers and lenders have continuous access to the information that allows them to make changes eliminating the price differences. However, if such were the case an "arbitrage paradox" would exist (Grossman and Stiglitz 1980). If arbitrage was never observed market participants would not have any incentive to monitor the markets continuously, in which case persistent opportunities for arbitrage would arise. The resolution of this paradox is that short-term arbitrage opportunities do arise, are noted by traders who exploit them, thus eliminating the opportunities (Akram et al. 2008).
  
−
== References ==
+
==Conclusion==
−
*Greider, William (1997). ''One World, Ready or Not''. Penguin Press. ISBN 0-7139-9211-5.
+
Arbitrage has many forms and encompasses many strategies; however, they all seek to take advantage of increased chances of success. Many of the the [[risk]]-free forms of pure arbitrage are typically unavailable to retail traders, although several types of risk arbitrage do offer significant profit opportunities to all arbitrageurs.
  
−
== External links ==
+
In the private sector, true arbitrage is completely [[Hedge (finance)|hedged]]. In other words, both sides of the transaction are guaranteed at the time the position is taken so there is no risk of loss. If Security X is selling in New York for $50 per share and in Chicago for $49.50, the arbitrageur would purchase shares in Chicago and sell them simultaneously in New York, making a profit of $0.50 per share. Transaction costs must, of course, be deducted from the spread (price differential or profit) and they may include commissions and interest, if money is borrowed to purchase the shares. Arbitrage differs from traditional investing in that profits are made by the trade itself, not from the appreciation of a security. In fact, holding securities long enough for them to change in value is generally considered a risk by the arbitrageur.
  
 +
Efficient markets do not, by definition, afford many opportunities for profit making through this type of trade, and arbitrage has been credited with contributing to market efficiency and “the [[law of one price]].” This does not mean that efficient markets afford no opportunities for arbitrage; in fact the "arbitrage paradox" implies that they should (Grossman and Stiglitz 1980). Indeed, short-lived arbitrage opportunities that provide significant profit do arise in the major foreign exchange and capital markets. These are the result of violations of the law of one price and covered [[interest rate parity]] (Akram et al. 2008).
  
−
*[http://economics.about.com/cs/finance/a/arbitrage.htm What is Arbitrage? (About.com)]
+
However, arbitrageurs have had to modify their approach in order to find new opportunities in increasingly efficient markets. Several factors have been instrumental in changing the nature of arbitrage over time; these include new market opportunities; new technology, especially in telecommunications and data processing; and advances in mathematical and statistical theory (Reverre, 2001). Riskless, or near riskless, profit opportunities without the need for actual work are so attractive to arbitrageurs that they continue to search and exploit them using whatever means necessary. In so doing, it appears that they also contribute to the smooth functioning of the market.
−
*[http://www.arbitrageview.com/riskarb.htm ArbitrageView.com] - Arbitrage opportunities in pending merger deals in the U.S. market
 
−
*[http://internetbabel.com/arbitrage-cash/ Online Arbitrage]
 
  
 +
== References ==
 +
*Akram, Farooq, Dagfinn Rime, and Lucio Sarno. 2008. [http://www.voxeu.org/index.php?q=node/2481 Arbitrage in the foreign exchange market: Turning on the microscope.] VoxEU.org. Retrieved June 7, 2019.
 +
*Bjork, T. 2004. ''Arbitrage Theory in Continuous Time''. Oxford University Press. ISBN 978-0199271269.
 +
*Burmeister, E., and K. D. Wall. 1986. The arbitrage pricing theory and macroeconomic factor measures. ''The Financial Review'' 21: 1-20.
 +
*Chen, N. F, and E. Ingersoll. 1983. Exact pricing in linear factor models with finitely many assets: A note. ''Journal of Finance'' 38 (3): 985-88.
 +
*Deardoff, Alan V. 2006. ''Terms of Trade: Glossary of International Economics''. World Scientific Publishing Company. ISBN 978-9812566034.
 +
*Greider, William. 1997. ''One World, Ready or Not''. Penguin Press. ISBN 0713992115.
 +
*Grossman, S. J., and J. E. Stiglitz. 1980. On the impossibility of informationally efficient markets. ''American Economic Review'' 70 (3): 393-408.
 +
*Kuepper, Justin. 2008. [http://www.investopedia.com/articles/trading/04/111004.asp Trading the Odds with Arbitrage.] ''Investopedia''. Retrieved June 7, 2019.
 +
*Prentis, Eric L. 2006. ''The Astute Investor''. Prentice Business. ISBN 978-0975966013.
 +
*Reverre, Stephane. 2001. ''The Complete Arbitrage Deskbook''. McGraw-Hill. ISBN 0071359958.
 +
*Roll, Richard. 1980. An empirical investigation of the arbitrage pricing theory. ''Journal of Finance'' 35 (5): 1073-1103.
 +
*Ross, Stephen. 1976. The arbitrage theory of capital asset pricing. ''Journal of Economic Theory'' 13(3): 341-360.
 +
*Tuckman, Bruce. 2002. ''Fixed Income Securities: Tools for Today`s Markets''. John Wiley & Sons, Inc. ISBN 0471063223.
  
 +
== External links ==
 +
All links retrieved August 11, 2023.
  
 +
*[https://www.thoughtco.com/overview-of-arbitrage-1146194 What is Arbitrage?] ThoughtCo.
  
 
{{Credits|Arbitrage|157211122|}}
 
{{Credits|Arbitrage|157211122|}}

Latest revision as of 21:31, 11 August 2023

Finance

BilleteiNTER II.jpg

Financial markets

Bond market
Stock (Equities) Market
Forex market
Derivatives market
Commodity market
Money market
Spot (cash) Market
OTC market
Real Estate market

Market participants

Investors
Speculators
Institutional Investors

Corporate finance

Structured finance
Capital budgeting
Financial risk management
Mergers and Acquisitions
Accounting
Financial Statements
Auditing
Credit rating agency

Personal finance

Credit and Debt
Employment contract
Retirement
Financial planning

Public finance

Tax

Banks and banking

Fractional-reserve banking
Central Bank
List of banks
Deposits
Loan
Money supply

Financial regulation

Finance designations
Accounting scandals

History of finance

Stock market bubble
Recession
Stock market crash

In economics and finance, arbitrage refers to the simultaneous sale and purchase of identical securities or other financial instruments on different markets to take advantage of price differentials for profit. This is also known as a "riskless profit."

Alternatively, arbitrage is attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. The ideal version is riskless arbitrage. Risk arbitrage, also known as "speculation," while technically not true arbitrage also exists in a variety of forms. Arbitrage is not illegal, although the temptation to make easy profit has led some to use confidential information about forthcoming situations for personal gain, an illegal activity known as insider trading.

Arbitrage opportunities are not necessarily available to all, and they are generally short-lived as the transactions affect prices so that the arbitrage opportunity is quickly eliminated. Nevertheless, the idea of profit that is essentially risk-free and requires no apparent work appears attractive to many who continue to seek and exploit arbitrage opportunities. Interestingly, it appears that they also contribute to market efficiency, a benefit to society as a whole.

Definition

Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. This usually takes place on different exchanges or marketplaces.

For example, a domestic stock may also trade on a foreign exchange in another country, where it has not adjusted for the constantly changing exchange rate. A trader may purchase the stock where it is undervalued and short sell the stock where it is overvalued, thus profiting from the difference.

When the purchase and sale transactions are simultaneous, it may be called riskless profit.

An individual who seeks out and takes advantage of arbitrage opportunities to make profit is known as an arbitrageur.

Since the actions of arbitrageurs influence the market, particularly in takeover situations there is a temptation for parties involved to communicate information about such activities to arbitrageurs in advance of any public announcement. This is known as insider trading and is generally illegal.

Etymology

Arbitrage is a French word and denotes a decision by an arbitrator or arbitration tribunal. (In modern French, arbitre usually means referee or umpire).

In the sense used in economics it was first defined in 1704 by Mathieu de la Porte in his treatise, La science des négocians et teneurs de livres as a consideration of different exchange rates to recognize the most profitable places of issuance and settlement for a bill of exchange ([U]ne combinaison que l’on fait de plusieurs Changes, pour connoître quelle Place est plus avantageuse pour tirer et remettre).

Conditions of arbitrage

I don't throw darts at a board. I bet on sure things. Read Sun-tzu, The Art of War. Every battle is won before it is ever fought.

These words come from the 1987 movie Wall Street, spoken by Gordon Gekko who makes a fortune as a pioneer of arbitrage.

Arbitrage opportunities exist when the "law of one price" is (temporarily) violated. This "law" states that: "In an efficient market all identical goods must have only one price." This is because all sellers flock to the highest prevailing price, and all buyers to the lowest current market price. In an efficient market the convergence on one price is instant. Under certain conditions, the convergence takes time, during which there exists an arbitrage opportunity.

In the derivatives market the law applies to financial instruments which appear different, but which resolve to the same set of cash flows. Any particular security must have a single price, although it may be created in a number of different ways. For example, if an option can be created using two different sets of underlying securities, then the total price for each would be the same. When they are not the same, an arbitrage opportunity exists.

Arbitrage is possible when one of three conditions is met (Kuepper 2008):

  1. The same asset does not trade at the same price on all markets
  2. Two assets with identical cash flows do not trade at the same price
  3. An asset with a known price in the future does not today trade at its future price discounted at the risk-free interest rate (or, the asset does not have negligible costs of storage; as such, for example, this condition holds for grain but not for securities)

Thus, to summarize: Arbitrage is not simply the act of buying a product in one market and selling it in another for a higher price at some later time. The transactions must occur simultaneously to avoid exposure to market risk, or the risk that prices may change on one market before both transactions are complete.

In practical terms, though, this is generally only possible with securities and financial products which can be traded electronically. Such risk-free trading is not available to everyone.

Types of arbitrage

In the world financial community, arbitrage refers to two basic types of activities. One requires little or no risk on the part of the investor, and the other can be highly speculative. As said above, in its purest form, arbitrage contains no element of risk. True arbitrage is a trading strategy that requires no investment of capital, cannot lose money, and the odds favor it making money. Any transaction or portfolio that is risk-free and makes a profit is also considered arbitrage.

The "market makers" (large firms operating on Wall Street, for example) have several advantages over retail traders (Kuepper 2008), including:

  • Great trading capital
  • More skill and experience
  • Instant news
  • More complex computer software
  • Access to the dealing deske

Market makers use complex software to locate arbitrage opportunities constantly. Once found, the differential is typically negligible, and requires a vast amount of capital in order to make a worthwhile profit; retail traders would lose their profit in commission costs. Thus, it is almost impossible for retail traders to compete in most types of arbitrage. Nevertheless, there are other arbitrage opportunities available.

Riskless or “true” arbitrage

Risk-less arbitrage is arbitrage when attempting to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms:

A combination of transactions designed to profit from an existing discrepancy among prices, exchange rates, and/or interest rates on different markets without risk of these changing. Simplest is simultaneous purchase and sale of the same thing in different markets (Deardoff 2006).

If an item can be bought for $5, and sold immediately for $20 on a different market, that is arbitrage. The $15 difference represents an arbitrage profit.

Arbitrage of this "One good, Two markets" variety is quite common in the world of sports gambling, since different betting agencies often post different odds on the outcome of a game. There are numerous bookmakers especially on the internet, and they offer a variety of odds on the same event. Any given bookmaker weights their odds so that no single customer can cover all outcomes at a profit. However, different bookmakers may offer different odds on the various outcomes. By taking the best odds offered by each bookmaker a customer may be able to cover all possible outcomes of the event and lock in a (small) risk-free profit.

Several other types of risk-less arbitrage exist (Reverre, 2001):

Inward arbitrage

This form of arbitrage involves rearranging a bank's cash by borrowing from the inter-bank market, and re-depositing the borrowed money locally at a higher interest rate. The bank will make money on the spread between the interest rate on the local currency, and the interest rate on the borrowed currency.

Inward arbitrage works because it allows the bank to borrow at a cheaper rate than it could in the local currency market. For example, assume an American bank goes to the Interbank market to borrow at the lower eurodollar rate, and then deposits those eurodollars at a bank within the U.S. The larger the spread, the more money that can be made.

Outward arbitrage

This form of arbitrage involves the rearrangement of a bank's cash by taking its local currency and depositing it into eurobanks. The interest rate will be higher in the inter-bank market, which will enable the bank to earn more on the interest it receives for the use of its cash.

Outward arbitrage works because it allows the bank to lend for more abroad then it could in the local market. For example, assume an American bank goes to the inter-bank market to lend at the higher eurodollar rate. Money will be shifted from an American bank's branch within the U.S. to a branch located outside of the U.S. The bank will earn revenues on the spread between the two interest rates. The larger the spread, the more will be made.

Triangular arbitrage

This is the process of converting one currency to another, converting it again to a third currency, and finally converting it back to the original currency within a short time span. This opportunity for riskless profit arises when the currency's exchange rates do not exactly match up. Triangular arbitrage opportunities do not happen very often and when they do, they only last for a matter of seconds. Traders that take advantage of this type of arbitrage opportunity usually have advanced computer equipment and/or programs to automate the process.

EXAMPLE: Suppose the following exchange rates exist:

EUR/USD = 0. 8631, EUR/GBP = 1. 4600 and USD/GBP = 1. 6939.

With these exchange rates there is an arbitrage opportunity. For example, starting with $1 million, the following transactions can be made:

  1. Sell dollars for euros: $1 million x 0.8631 = 863,100 euros
  2. Sell euros for pounds: 863,100/1.4600 = 591,164.40 pounds
  3. Sell pounds for dollars: 591,164.40 x 1.6939 =$1,001,373 dollars

These transactions yield an arbitrage profit of $1,373 (assuming no transaction costs or taxes) which is the positive difference between the three “almost” simultaneous transactions leading to $1,001,373, from which one subtracts the original outlay of $1,000,000 to yield of net profit of $1,373.

Risk arbitrage

Risk arbitrage, unlike “true” or risk-less arbitrage, does entail risk. Although considered "speculation," risk arbitrage has become one of the most popular (and retail trader friendly) forms of arbitrage.

EXAMPLE: Corporation A trades trading at $12 per share. Corporation B determines to acquire Corporation A, placing a takeover bid on Corporation A for $16 per share. This means that all shares in Corporation A increase their value to $16 per share, although they are trading at only $12 per share.

Early trades bid the price up to $15 per share. A $1 per share difference still exists—an opportunity for risk arbitrage. The risk lies in the probability that the acquisition might fail to take place, in which case the shares would be worth only the original $12 per share.

Some of the most common forms of risk arbitrage available to retail traders include:

Statistical arbitrage

This is an attempt to profit from pricing inefficiencies that are identified through the use of mathematical models. Statistical arbitrage attempts to profit from the likelihood that prices will trend toward a historical norm. It is an equity trading strategy that employs time series methods to identify relative mispricings between stocks (Ross 1976, Burmeister 1986).

Pairs trading

Pairs trading, also known as relative-value arbitrage, is a far less common form (Reverre 2001). This form of arbitrage relies on a strong correlation between two related or unrelated securities. It is primarily used during sideways markets as a way to profit.

The basis of this arbitrage is finding "pairs." Typically, high-probability pairs are stocks in the same industry with similar long-term trading histories. One example of securities that would be used in a pairs trade is GM and Ford. These two companies have a 94 percent correlation which means that both securities mapped on the time plot move almost exactly in parallel. If a significant divergence occurs, the chances are high that these two prices will eventually return to a higher correlation (the parallel behavior), offering an opportunity in which profit can be attained (Kuepper 2008).

Takeover and merger arbitrage

The earlier example of risk arbitrage involving the acquisition of Corporation A by Corporation B demonstrates takeover and merger arbitrage. It is probably the most common type of arbitrage. This typically involves an undervalued business that has been targeted by another corporation for a takeover bid. The takeover bid raises the value because in order to purchase the target corporation they must offer to buy their stock at higher than market price. Once the takeover is announced, the market price price rises to (or at least close to) that offered price. By identifying a company targeted for takeover arbitrageurs can buy stock at the pre-takeover price and sell them after the takeover has been completed at the higher price. If the merger or takeover goes through successfully, all those who took advantage of the opportunity make a significant profit; if it falls through, however, the price usually falls. That is, the element of risk that is always there.

The key to success in this type of arbitrage is speed; traders who utilize this method usually have access to streaming market news. Within seconds of an announcement they can act, before regular retail traders. However, even though retail traders are not the first to take advantage of a merger arbitrage opportunity, there is still some chance of profit. Benjamin Graham developed a risk-arbitrage formula to determine optimal risk/reward (Graham and Buffet 1985). The equations state the following:

Annual Return = [C. (G-L). (100%-C)] /YP, where:

  • C is the expected chance of success (percent)
  • P is the current price of the security
  • L is the expected loss in the event of a failure (usually original price)
  • Y is the expected holding time in years (usually the time until the merger takes place)
  • G is the expected gain in the event of a success (usually takeover price)
Liquidation arbitrage

This type of arbitrage involves identifying companies that have a higher liquidation value than their market price. For example, a business has a book value of $15 per share but is trading at $12 per share. If the business is liquidated its share rise to the higher value. In the Wall Street movie, Gordon Gekko bought companies, breaking them apart and selling them at higher prices, and was able to realize significant profit through this type of arbitrage.

Fixed income trading

Fixed income arbitrageurs try to identify when historical patterns for spreads or term structure relationships have been violated and there is anticipation of the historical relationship being re-established. They also look for situations where credit risk or liquidity risk is being over compensated.

Central bank intervention in the markets often creates abnormalities that can be exploited. A typical example is the 2008 crash of the sub-prime mortgage market in the U. S. Apart from the multi-billion losses, there was an opportunity to make a profit on the expectation that the Federal Reserve would eventually step in and invigorate the market, albeit for a short-term.

Fixed income arbitrage strategies are generally implemented to be duration neutral, but they are exposed to various other market risks. By their nature, particular strategies may be exposed to tilts in the term structure, spread risk, and foreign exchange risk.

Convertible-bond arbitrage

A convertible bond is a bond that an investor can return to the issuing company in exchange for a predetermined number of shares in the company. A convertible bond can be thought of as a corporate bond with a stock call option attached to it (Chen, 1983). Given the complexity of the calculations involved and the convoluted structure that a convertible bond can have, an arbitrageur often relies on sophisticated quantitative models in order to identify bonds that are trading cheap versus their theoretical value (Ross 1976, Burmeister 1986).

The price of a convertible bond is sensitive to three major factors:

  1. Interest rate: When rates move higher, the corporate bond part of a convertible bond tends to move lower, but the call option part of a convertible bond moves higher (and the aggregate tends to move lower).
  2. Stock price: When the price of the stock the bond is convertible into moves higher, the price of the bond tends to rise.
  3. Credit spread: If the creditworthiness of the issuer deteriorates (for example, rating downgrade) and its credit spread widens, the bond price tends to move lower, but, in many cases, the call option part of the convertible bond moves higher (since credit spread correlates with volatility).

Convertible arbitrage consists of buying a convertible bond and hedging (making an investment specifically to reduce or cancel out the risk in another investment) two of the three factors in order to gain exposure to the third factor at a very attractive price (Bjork 2004, Chen 1983). For instance an arbitrageur would first buy a convertible bond, then sell fixed income securities or interest rate futures (to hedge the interest rate exposure) and buy some credit protection (to hedge the risk of credit deterioration).

Eventually what is left is something similar to a call option on the underlying stock, acquired at a very low price. Profit can then be made either selling some of the more expensive options that are openly traded in the market or delta hedging his exposure to the underlying shares.

Price convergence

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets tend to converge to the same prices, in all markets, in each category. The speed at which prices converge is a measure of market efficiency. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell it where the price is high, as long as the buyers are not prohibited from reselling and the transaction costs of buying, holding and reselling are small relative to the difference in prices in the different markets.

Arbitrage moves different currencies toward purchasing power parity. Similarly, arbitrage affects the difference in interest rates paid on government bonds issued by the various countries, given the expected depreciations in the currencies relative to each other.

Efficient financial markets should operate without allowing the existence of arbitrage opportunities, since potential borrowers and lenders have continuous access to the information that allows them to make changes eliminating the price differences. However, if such were the case an "arbitrage paradox" would exist (Grossman and Stiglitz 1980). If arbitrage was never observed market participants would not have any incentive to monitor the markets continuously, in which case persistent opportunities for arbitrage would arise. The resolution of this paradox is that short-term arbitrage opportunities do arise, are noted by traders who exploit them, thus eliminating the opportunities (Akram et al. 2008).

Conclusion

Arbitrage has many forms and encompasses many strategies; however, they all seek to take advantage of increased chances of success. Many of the the risk-free forms of pure arbitrage are typically unavailable to retail traders, although several types of risk arbitrage do offer significant profit opportunities to all arbitrageurs.

In the private sector, true arbitrage is completely hedged. In other words, both sides of the transaction are guaranteed at the time the position is taken so there is no risk of loss. If Security X is selling in New York for $50 per share and in Chicago for $49.50, the arbitrageur would purchase shares in Chicago and sell them simultaneously in New York, making a profit of $0.50 per share. Transaction costs must, of course, be deducted from the spread (price differential or profit) and they may include commissions and interest, if money is borrowed to purchase the shares. Arbitrage differs from traditional investing in that profits are made by the trade itself, not from the appreciation of a security. In fact, holding securities long enough for them to change in value is generally considered a risk by the arbitrageur.

Efficient markets do not, by definition, afford many opportunities for profit making through this type of trade, and arbitrage has been credited with contributing to market efficiency and “the law of one price.” This does not mean that efficient markets afford no opportunities for arbitrage; in fact the "arbitrage paradox" implies that they should (Grossman and Stiglitz 1980). Indeed, short-lived arbitrage opportunities that provide significant profit do arise in the major foreign exchange and capital markets. These are the result of violations of the law of one price and covered interest rate parity (Akram et al. 2008).

However, arbitrageurs have had to modify their approach in order to find new opportunities in increasingly efficient markets. Several factors have been instrumental in changing the nature of arbitrage over time; these include new market opportunities; new technology, especially in telecommunications and data processing; and advances in mathematical and statistical theory (Reverre, 2001). Riskless, or near riskless, profit opportunities without the need for actual work are so attractive to arbitrageurs that they continue to search and exploit them using whatever means necessary. In so doing, it appears that they also contribute to the smooth functioning of the market.

References
ISBN links support NWE through referral fees

  • Akram, Farooq, Dagfinn Rime, and Lucio Sarno. 2008. Arbitrage in the foreign exchange market: Turning on the microscope. VoxEU.org. Retrieved June 7, 2019.
  • Bjork, T. 2004. Arbitrage Theory in Continuous Time. Oxford University Press. ISBN 978-0199271269.
  • Burmeister, E., and K. D. Wall. 1986. The arbitrage pricing theory and macroeconomic factor measures. The Financial Review 21: 1-20.
  • Chen, N. F, and E. Ingersoll. 1983. Exact pricing in linear factor models with finitely many assets: A note. Journal of Finance 38 (3): 985-88.
  • Deardoff, Alan V. 2006. Terms of Trade: Glossary of International Economics. World Scientific Publishing Company. ISBN 978-9812566034.
  • Greider, William. 1997. One World, Ready or Not. Penguin Press. ISBN 0713992115.
  • Grossman, S. J., and J. E. Stiglitz. 1980. On the impossibility of informationally efficient markets. American Economic Review 70 (3): 393-408.
  • Kuepper, Justin. 2008. Trading the Odds with Arbitrage. Investopedia. Retrieved June 7, 2019.
  • Prentis, Eric L. 2006. The Astute Investor. Prentice Business. ISBN 978-0975966013.
  • Reverre, Stephane. 2001. The Complete Arbitrage Deskbook. McGraw-Hill. ISBN 0071359958.
  • Roll, Richard. 1980. An empirical investigation of the arbitrage pricing theory. Journal of Finance 35 (5): 1073-1103.
  • Ross, Stephen. 1976. The arbitrage theory of capital asset pricing. Journal of Economic Theory 13(3): 341-360.
  • Tuckman, Bruce. 2002. Fixed Income Securities: Tools for Today`s Markets. John Wiley & Sons, Inc. ISBN 0471063223.

External links

All links retrieved August 11, 2023.

Credits

New World Encyclopedia writers and editors rewrote and completed the Wikipedia article in accordance with New World Encyclopedia standards. This article abides by terms of the Creative Commons CC-by-sa 3.0 License (CC-by-sa), which may be used and disseminated with proper attribution. Credit is due under the terms of this license that can reference both the New World Encyclopedia contributors and the selfless volunteer contributors of the Wikimedia Foundation. To cite this article click here for a list of acceptable citing formats.The history of earlier contributions by wikipedians is accessible to researchers here:

The history of this article since it was imported to New World Encyclopedia:

Note: Some restrictions may apply to use of individual images which are separately licensed.

Retrieved from https://www.newworldencyclopedia.org/p/index.php?title=Arbitrage&oldid=1119852

Content is available under Creative Commons Attribution/Share-Alike License; additional terms may apply. See Terms of Use for details.
Copyright Logo
Powered by MediaWiki